Originally published at Project-Syndicate | July 27th, 2022
The European Central Bank’s new Transmission Protection Instrument is as ambitious as it is risky. Not only does it involve the central bank in tasks that lie far outside its remit, but it has also been unveiled at a time when monetary policymakers should be focused squarely on maintaining price stability.
FRANKFURT – In mid-June, as the yield on Italian ten-year bonds was rising to around 250 basis points above that of German bonds, the European Central Bank felt it necessary to hold a special Governing Council meeting to announce accelerating work on a new “anti-fragmentation” measure. And now, it has unveiled the fruit of its effort.
The ECB’s Transmission Protection Instrument is supposed to “ensure that the monetary policy stance is transmitted smoothly across all euro area countries,” according to the official announcement. “The TPI will be an addition to [our] toolkit and can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area.”
The TPI is an ambitious and risky undertaking for the ECB, considering how difficult it is to determine the extent to which spreads (the difference between different countries’ bond yields) reflect differences in underlying fundamentals, as opposed to unjustified and destabilizing market dynamics. Moreover, there will always be a significant political element in such judgment calls, which ensures that they will be tested by markets. As a result, the ECB inevitably will feel greater pressure to intervene more strongly than is justified by the economic and financial fundamentals of the country concerned.
To decide if market risk premia are justified by fundamentals, the ECB Governing Council ultimately must offer an opinion about whether a member state’s future economic, financial, and social policy decisions will be sound. But it is not the task of an independent central bank to make extensive judgments about future government policies, nor to fine-tune individual countries’ funding costs with policies that have potentially far-reaching political consequences.
The ECB’s Outright Monetary Transactions (OMT) program invited the same basic objection. Maintaining eurozone cohesion is primarily the responsibility of national governments, which must ensure that their policy decisions comply with the conditions of a stability-oriented monetary union. The job of supporting a crisis-afflicted member state belongs not to the central bank but to the community of member-state governments.
But the OMT at least has some important advantages over the TPI, starting with the conditions that it imposes on member states that seek support. Conditionality is crucial to prevent the central bank from becoming an engine of monetary financing. As then-ECB President Mario Draghi explained in a May 6, 2013, speech:
“The bond-issuing governments which request the activation of OMTs agree, in conjunction with the European authorities and, if possible, with the International Monetary Fund, on a recovery program to address macroeconomic and structural weaknesses. This is a necessary, but not sufficient, condition … The conditionality associated with the program to which governments and the European authorities agree is a crucial element in being able to preserve monetary policy independence. It is important in providing the ECB with adequate assurance that interventions supporting sovereign debt bond prices do not mutate into financial subsidies for unsustainable national policies in the medium term.”
The TPI’s eligibility criteria seem to fall far short of the conditions that Draghi attached to the OMT. That puts the ECB in dangerous territory. The more it uses its own discretion to decide on TPI eligibility, the more it will be playing a role reserved for elected governments. Moreover, markets and member states with high public debts will adjust their expectations, anticipating that the TPI will allow for even more debt to be accumulated without an adequate increase in risk premia (and thus interest-rate spreads).
The ECB took this radical step without any evidence that the mid-June increase in spreads was unjustified. In the future, “The Governing Council will consider a cumulative list of criteria to assess whether the jurisdictions in which the Eurosystem may conduct purchases under the TPI pursue sound and sustainable fiscal and macroeconomic policies.” Again, this represents a dangerous departure from the approach adopted under the OMT.
The OMT applied a “strict and effective conditionality” requiring detailed fiscal and structural policy commitments by the recipient government, as well as commitments from other member states to provide financial assistance loans via the European Stability Mechanism. For a member state to receive support, the ESM and the European Commission would have had to sign a Memorandum of Understanding detailing an adjustment program by which it would make its debt burden sustainable. The point of these steps was to ensure that all member states, the ESM, and the Commission all had “skin in the game” (both reputational and financial).
By contrast, the TPI does not require an ESM adjustment program, and thus would impose a much greater reputational and financial burden on the ECB than the OMT scheme ever did. Worse, not only are debt levels much higher now, but eurozone member states’ economic prospects are weaker. Under these circumstances, it is difficult to see how the TPI’s substantially weaker conditionality can be justified.
The TPI thus threatens to reverse a crucial achievement of the last decade. There is a reason why the ESM was established as the key institution to deal with fiscal problems in individual member states, and why its programs required backing by parliamentary decisions in all eurozone countries. It was understood that the ECB should not play a role that must be performed by elected officials who are responsible to voters.
This division of labor has become even more important now that inflation is running four times higher than the ECB’s target. The central bank’s main job is to ensure that inflation expectations are well anchored, so that high inflation does not become entrenched. Fulfilling that mandate requires decisive policy action. The ECB should be going to great lengths to dispel any doubt that it is not focused squarely on its primary objective. Instead, it has devoted its time and energy to designing a scheme that is economically dangerous and politically treacherous.
Otmar Issing: Former chief economist and member of the board of the European Central Bank, is President of the Center for Financial Studies at Goethe University Frankfurt.